These Stocks Will Burn You

Unless, that is, you follow a few simple steps.

In his article "The Market's 10 Best Stocks," my colleague Tim Hanson pointed out the benefits of searching for the next multibagger success stories among the smallest of companies.

And I agree with him: The best stocks of the next decade will not be huge companies. Why not? This chart should explain why. Look how large each of these solid businesses would become if they increased just 10 times in value over the next decade.

Company

Market Cap (billions)

10-Bagger Market Cap (trillions)

Johnson & Johnson(NYSE:JNJ)

$201.9

$2.0

American International Group(NYSE:AIG)

$172.1

$1.7

JPMorgan Chase(NYSE:JPM)

$162.4

$1.6

Chevron(NYSE:CVX)

$143.5

$1.4

Wells Fargo(NYSE:WFC)

$127.0

$1.3

Verizon(NYSE:VZ)

$108.7

$1.1

While it's certainly possible, we probably won't have a trillion-dollar company by 2016 -- much less see any of these large caps turn into 20- or 30-baggers. So we can count the giants in that chart out of the running for best performer of the next decade.

Instead, the greatest chance for the greatest gains comes from the smallest of companies, like the Tiny Gems followed by Tom Gardner and the Motley Fool Hidden Gems team. These half-pints are capitalized at less than $200 million, and there's plenty of room for them to grow before they run into the headwinds of large numbers and their prospects become more limited.

But before you take a free trial and jump headfirst into the micro-cap waters, listen up: This ride is not for everybody.

Buckle upWith great potential reward comes great risk. Just as a tiny company has the greatest chance at outlandish gains, it also has a better chance of going belly-up -- bankrupt. Gone ... along with your money. And the volatility along the way to greatness or the graveyard may give you whiplash.

Thus, these Tiny Gems are best suited for risk-tolerant investors with a long-term outlook.

That said, two things can greatly reduce the chance that your portfolio will get torched by tanking tinies:

Believe the balance sheet. This is where you can tell whether a company is in danger. Little cash and large amounts of debt are a big warning sign, especially for businesses not yet turning a profit. Go back through the last several balance sheets. Is the company burning through cash? How fast? My advice: Stick to profitable companies with cash-to-debt ratios of at least 1.5.

Buy a "basket" of these micro caps. In other words, allocate the amount of funds you normally would for one stock to several of the tinies: four or five, for example. That way, you're giving yourself more of a chance of finding at least one huge gainer, which will more than make up for one or two of the others losing most of their value.

Are you still ready to forge onward to Tinyland? Good. Click here for a free trial to Hidden Gems. The newsletter's official small-cap recommendations (which are larger than Tiny Gems) have returned an average of 31% since inception, versus 17% for identical amounts invested in the S&P 500.

This article was originally published on Jan. 30, 2006. It has been updated.

Author

Rex Moore spent his formative years in Texas, and fought beside Davy Crockett at the Alamo. He currently travels the globe for TMF, bringing back video reports on conferences and companies that matter for investors.